Collateralized Debt Obligation (CDO)

Today I was watching the questioning of Credit rating agency chiefs by the Congress members. They had to justify on why the rating calls could not pick up bad instruments much before the system collapsed. All I heard was diplomatic answers to the questions from the members of the congress. None of the answers would conclusively result in solutions to avoid such events in future.

While hearing all of this, there is one more instrument, which is Collateralized debt obligation (CDO) which could result in the ripple effect from the failure of a Credit Default Swap (CDS). A CDO is an instrument where debt of firms is clubbed together. What makes this instrument sweeter is the was in which they are packaged; the debt of 100 or more companies is clubbed together such that the companies with a higher default risk are compensated by companies with lower ones. This results in higher credit rating eventually. Wachovia tells Bloomberg that $254 billion worth of CDOs have defaulted so far. Today in the questioning the President of the credit rating agency division in Standard & Poor’s, who joined the firm in September last year told the Congress people that on an average the model of rating of instruments was revised as many as 2.5 times in a year. One could very well infer here that the experts could have caught the bad debt and the resulting systemic collapse well before, as the model would have evolved with respect to changing (deteriorating) economic conditions. Even though these instruments can be very complex in nature, hence difficult to rate; definitely it should not be used as an excuse by people who make a living off rating these instruments. Now a buyer of these instruments has no direct exposure to the underlying debt / loan instruments but relies solely on the ratings assigned to the CDO as a whole and would fail to correctly access his risk exposure.

The banks in Iceland too have been reported to have heavy exposure to the CDOs and it’s sad to see reports such as an entire country going bankrupt. As reported in Bloomberg, Barclays Capital estimates that 70 percent of synthetic CDOs sold swaps on Lehman. So it is not hard to understand what kind of mess Lehman was in. As selling the CDO is relatively simpler due to nature in which they are packaged, the seller normally an investment bank would make a commission. On the other hand it allows firms to pool their debt and hide away their losses. What makes this instrument more prone to failure is the mark-to-market accounting basis. The domino effect would come now as the CDOs have part exposure to fixed income products in the form of a Credit Default Swap (CDS). The CDS mess has already become like a folklore and will be used as case studies in times to come.

What if the Government doesn't intervene now...

There seems to be a debate whether the government should intervene and rescue the homeowners and lenders alike. What happens incase the government or the Federal Reserve doesn't intervene. Many think that if the Government doesn't do anything now, home prices will find a equilibrium based on fundamentals rather than what has pushed up prices over the last few years. Home prices might very well fall below the whatever the fundamental price needs to be, same way the prices did over shoot on their way up. When no one knows what the bottom is going to be, lenders wont be ready to lend at what they think are over priced houses. Buyers even if they want to will not be able to buy if there is no money to borrow. This in turn will push the prices down. Falling prices will deter new home buyers from buying since they would be waiting for the prices to fall still further.

Even if there are moral issues in helping the homeowners and the lenders who got us into this mess, Government and the Federal Reserve need to act to stop the financial industry from collapsing.

US Home Loans vs. Indian Home Loans

Swaminathan S Anklesaria Aiyar in The Sunday Times has written a great article by reasoning why a Subprime mess is not likely to take place in India. Is this definitely an eye opener.

Read the article here.

Also, I feel he’s a great writer and some of his earlier articles are also gems. So please find the list of other articles here.

Here’s a small excerpt.

A housing boom-and-bust has engulfed the US financial sector in crisis. India, too, has experienced a runaway real estate boom, which in a few areas is going bust. The share prices of real estate companies have crashed. Yet, India has no mortgage crisis or financial sector crisis.

Why not? Mainly because of the huge amount of black money in Indian real estate. This has saved the Indian financial sector in unexpected ways. Traditionally, US mortgage lenders checked the creditworthiness of borrowers, and then made the borrower pay at least 20% of the house value, loaning the remaining 80%. So, even if the price of the house dipped, it would still be higher than the bank's loan, and the borrower had an incentive to repay it.

Also if I may add, buying a house in India involves a lot of sentimental factors associated with it. The strong family ties, concept of a joint family or living with your parents also serve as a deterrent to just switching houses or walking away from one. While the amount of black (illegal) money in circulation in India is certainly not advocated it’s an interesting outlook into how the home loan market in India works.

Is JP Morgan in a Quagmire?

Mr. Jamie Dimon, Chairman and Chief executive of JP Morgan recently raised the bid price for Bear Stearns to $10 a share which takes the bid to $2.1 billion. This is supposed to be a fair deal, or at least fairer than the last offering, much to please the investors and the employees. But still 1/3^rd less than the valuation on March 14, 2008. Valuations and the actual crisis at Bear Stearns aside the earlier valuation of $240 million or so was really a joke for a firm like Bear Stearns. The bailout by the Fed will be in end be financed by American tax payers money. One can argue that the actual fall would have been even more damaging to the American financial system.

Bear Stearns currently owns $30 billion of least liquid assets out of which $29 billion will be financed by the Fed and JP Morgan will bear losses of $1 billion. JP Morgan already has set aside $6 billion for lawsuits and merger costs. This is three times more than the cost of acquisition itself . Besides being big in home equity loans (read subprime mess), it is number one in the US in Credit Default Swaps. This really should be worrying.

What is a Credit Default Swap (CDS) anyway?

It’s an agreement between two parties to take responsibility for the credit risk for a third party entity can offer.

Alright, so what does it mean?

For a buyer:

A buyer will pay a periodic fee to a seller of a CDS to offer him protection in case a third party is to default on a payment. This offers him guarantee that his liability over this credit risk is limited.

For Seller:

In case a third part defaults on credit taken the seller of a CDS has to pay the buyer of a CDS with whatever sum agreed. The seller here can either take over the defaulted credit position or pay upfront to the buyer of a CDS whatever is the difference.

Mr. Dimon has sure has a tough task at hand at merging Bear Stearns and keeping his own firm in sound financial health.

Time magazine here has an excellent write up regarding a potential CDS crisis.

STOP THIS ..... Please

Take a look at the ad presented by Countrywide, it advertises about home loans without a credit report. Is this not what has brought the financial industry to its knees. Lenders ready to lend money to earn the commission and then sell the loan to a bigger Investment bank so that the risk is distributed. Borrowers borrowing more money than what they can afford. This has lead to the sub prime mortgages to turn sour and billions of dollars of securities to be worthless. A simple example of what's happening in the sub prime market here. I feel the Federal Reserve needs to come up with a better regulations to stop this.

Technorati Tags: Economy,Fed,SubPrime

Is Merrill Lynch safe ??

The fall of Bear Sterns, the fifth largest Investment bank on Wall street, raises a few doubts in my mind about the safety of others in the same Business. Bear Sterns was bought by JP Morgan for $2  a share i.e something like $236 million for the bank. The Bear Sterns building is estimated to be worth a billion dollars, still it was sold for $236 million that puts into perspective the liabilities the bank currently had. It was sitting on a lot a mortgage backed securities which was turned useless in the current market situation. The leverage obtained from such securities allowed Bear Sterns to post profitable quarter after quarter.

Merrill Lynch is currently sitting on an Investment of $1 trillion dollars with a base equity of $30 billion dollars. Leverage is a great thing to make profits, but when the markets take a turn for the worse, a small in the asset values can wipe the shareholders value. I do not believe in the statements made by the Bank about the liquidity they have currently, after all the Bear Sterns CEO on tuesday made a statement that they had enough liquidity to see this bad phase through and on Friday the Bank was sold to JP Morgan.

Luckily the Federal Reserve has taken active measures to pump liquidity into the Financial System. The Fed chairman Ben Bernake (A scholar on the 1930 depression ) has taken some innovative steps to stop the Financial System from collapsing. Both Lehman Brothers and Goldman Sachs reported better than expected earnings for this quarter. The Bernake solution seems to be working, it should help the Investment banks to stay solvent and do what they are supposed to do help foster economic growth.

Feds new tool TSLF

Traditionally the US Federal Reserve(Fed) had three ways to run the monetary policy namely cutting interest rates, cutting reserve requirements and cutting the discount rate. The Fed today came up with an innovative way of dealing with the credit crunch in the financial markets. The financial markets were expecting more than mere rate cuts from the Fed, some way the Fed could buy the mortgage linked securities and bring some confidence back into the Financial markets. The financial media Wall Street Journal, Bloomberg,  CNN Money had articles(linked here) with expectations and predictions about what the Fed might do.

Step in TSLF

TSLF is Term Security Lending facility, This is the Fed's new way of increasing liquidity into the System. What the Fed says is that the Banks can exchange the their mortgage backed securities for treasury bonds on a temporary basis. This should take off the pressure of the mortgage backed securities from the balance sheets of the banks and allow them to lend and borrow in a much more free way. Banks can exchange up to $200 billion dollars of mortgage securities at this moment. With this announcement, Fed probably closed the door on the 75 basis point cut in the increase rates. Stock markets have taken the Fed move in a very positive way with the Dow gaining more than 3.5 percent, even though there was a fall in the Healthcare stocks(More about that in my next post). Indian markets have also continued their recovery, the BSE sensex is 400 points up at this point. The only problem with the TSLF is incase the mortgage securities start defaulting in a big way, the Fed could be holding on to something worthless. Right now the Fed has said that they are going to buy only top rated securities. (BusinessWeek has a nice article on TSLF )

Subprime Equilibrium

Credit crunch, liquidity being sucked out of the system, FIIs not pumping the money, more bad news in the form of Blackstone profits (one of the major investors in India) and crude oil trading at $108 - 109 levels. Life on the stock markets is really tough these days.

Today though, the Indian stock markets showed some signs of recovery. There should be more on Wednesday based on US Federal Reserve decision to lend up to $200 billion to banks and lenders and ease liquidity. The Dow too as I write this is posting good gains based on the central bank’s decision. The US Fed Reserve is really taking some steps to thwart recession and hopefully it works for the US economy and of course that would mean good news to us too.

Point is when the Indian economy was in such good gear just 2 quarters back, has the tide turned really and all developmental activities leading to India’s growth halted. Or is it just a case of the confidence being low all over, more so because of global factors. Such that it has become a wait and watch game for Indian investors. However strong the domestic growth story may be, there is no denying the impact of the rupee on exporters even others than in the services sector. Their margins have got squeezed and which in turn has affected the local players supplying them.

So when is all this going to balance out? How long is long term to stay put in the stock markets. The rupee is going to get stronger as soon as FII start pumping money again on account of Indian growth story which in turn would hurt exporters or till the FIIs don’t pump in money the stock markets will keep searching for directions and which will hurt investor sentiments. It’s time to get the fundamentals in shape such that the Indian growth story remains intact and still provides value. It’s a time reassess business strategies and growth drivers such that investors have confidence in India and come in droves.

Where does this end .....

We have all heard that the Banks are having problems with their exposure to the subprime mortgages and their financial troubles have caused a massive credit crunch in the financial markets all around the world. The absence of liquidity has caused a blood bath in the financial markets all around the world. All the big investment banks have declared multi billion dollar write off due to this. This has also led to the collapse of many of the hedge funds that were giving spectacular results till now. Read here about the anatomy of a hedge fund collapse. Where does all this stop, stocks around the world have lost more than thirty percent from their peaks or more, US might already be in a recession; According to me the next important thing is the results of the big investment banks. If they have accounted for all the sub prime write offs then we should be good, if there is more to be lost to that, the uncertainty will cause more harm. The US consumer will have the checks from the economics stimulus package (Details Here ) sometime in May, that should help the flagging economy. All in all another three four months before we see some kind of consistent recovery across the stock markets.